Common LLC Legal Issues

Common LLC Legal Issues

If you’re new to entrepreneurship and considering forming a limited liability company (LLC) for your new business, fully understanding the ins and outs of an LLC is important to help you avoid common pitfalls. Some mistakes that LLC members make can even lead to legal issues, which can seriously impact the future of the business.

Here you’ll learn about some common LLC legal issues and what to do to avoid them.

Liability

Most entrepreneurs choose to form an LLC simply due to the fact that it offers personal liability protection. However, you have to understand that liability protection has limits, as the name states.

First of all, it’s important to keep the line drawn between your business and you personally. If you do anything that blurs that line, it can be argued in court that your personal liability protection is not applicable. The most common way the separating line gets blurred is when LLC members commingle business and personal finances. You absolutely must have a business bank account and use it for all business-related transactions to keep your personal liability protection intact.

Second, personal liability protection does not apply if you or another member commits fraud or acts illegally or recklessly when managing the company. If that can be proven in court, you will be held personally liable in the case of a lawsuit.

Finally, if you personally guarantee a business loan, which is a common requirement, you are personally liable for that debt if the LLC is unable to pay. If you aren’t able to personally pay, your personal assets will be at risk unless you file for personal bankruptcy, which may be difficult if you have assets.

Lack of Operating Agreement

One of the most common but critical errors that LLC members make is not having an operating agreement. One is not required in most states, so entrepreneurs think they can skip this step when starting a new small business and forming an LLC.

An operating agreement specifies the ownership percentages of members, how profits and losses are allocated and distributed, and how member disputes are resolved, as well as many other important provisions.

The lack of an operating agreement, or one that is not clear, can lead to all sorts of legal issues, the most common being founder disputes that end up in court. State default rules will apply in such cases, but those laws don’t cover every situation, so legal battles can get messy and often lead to the dissolution of the LLC.

The lack of an operating agreement can also cause issues when seeking funding either from a lender or investor. Investors in particular need a clear path to taking equity in the company, and without an operating agreement, that path does not exist.

Additionally, the operating agreement will specify how the LLC can be dissolved. If the members ever choose to dissolve the LLC and an operating agreement does not exist, they may have to go to court to seek a judicial dissolution.

The bottom line is that it’s absolutely critical to have an operating agreement in place, or you risk facing some of these issues in the future.

Tax Issues

LLC taxes are fairly straightforward in terms of profits and losses, since an LLC offers pass through taxation, meaning that profits or losses are passed through to the owners to be personally reported on their tax returns.

However, it’s common for an LLC to elect to be taxed as an S Corporation when the LLC reaches a certain level of income. Often, LLC members decide to take this election when it becomes financially beneficial due to self-employment tax savings. However, they don’t understand the requirements that come with S-Corp status.

An S-Corp is subject to the corporate rules of the state, including the requirements to appoint officers and elect a board of directors. They also have to create corporate bylaws and follow corporate meeting requirements.

Additionally, when an LLC elects S Corp status, the members become shareholders, and they must be paid a reasonable salary for their role in the company before they can be paid dividends or take distributions. If you don’t do this, you risk owing back self-employment taxes, along with interest and penalties.

Other types of tax issues can come for failing to collect and pay sales taxes or payroll taxes.

Involuntary Dissolution

In many states, failing to properly file LLC reports and pay fees, or to follow other state requirements can lead to an involuntary dissolution of the LLC. It can also occur for failing to pay any required state taxes. This often occurs when an LLC operates in more than one state, and the LLC members fail to follow the regulations and meet the requirements of all the states where they do business.

Often, LLC members are also not even aware that they need to register as a foreign LLC in any other states where they do business. This can lead to monetary penalties being imposed on both the business and its members.

Trademark Issues

When you first form an LLC and choose a name, the state will only approve your LLC if your chosen name is not already being used in the state. You can easily check name availability in your state, usually on the Secretary of State’s website.

However, your next step should be to check to make sure the name is not nationally trademarked. Often, entrepreneurs skip this step, even though it’s a simple process to do a search on the United States Patent and Trademark Office’s website.

If you use a name that is trademarked, it could lead to lawsuits that could result in monetary damages. You would also be forced to change your LLC name, which could seriously impact your business.

In Closing

The good news is that all of these legal issues can be prevented!  You can avoid all the mistakes that many other entrepreneurs have made, giving your new business a much better chance of success. You should also keep your attorney’s number handy, so that if you’re ever in doubt about what you’re doing, you can get professional advice.